An extremist, not a fanatic

February 11, 2016

Should we nationalize banks?

What I mean is that banks are risk-magnifiers. When they lose money, credit to the whole economy gets choked off, thus causing recession. Banks are critical hubs in a network economy.

Put it this way. In the 2008 financial crisis, the US’s biggest financial institutions lost between them less than $150bn. But during the tech crash of 2000-03 investors in US stocks lost over $5 trillion. The former led to a great depression, the latter to only the mildest of downturns. Why the difference? One big reason is that losses are easier to bear if they are spread across millions of (mostly unleveraged) people, but cause real trouble if they are concentrated in a few leveraged strategically important institutions.

One reason why non-financial stocks have fallen recently is that investors fear a repeat of 2008 – a fear which is all the greater because banks are so opaque. Yes, the bosses of Deutsche and Credit Suisse claim that they are sound – but nobody believes bosses these days. As Nicholas Taleb said, bankers are “not conservative, just phenomenally skilled at self-deception by burying the possibility of a large, devastating loss under the rug.”

I suspect the CAPM has got things backwards. It says that banks fall a lot when the general market falls because they are, in effect, a geared play upon the general market. But sometimes, the market falls because banks fall.

Which leads me to the case for nationalization. This wouldn’t prevent banks losing money: these are inevitable sometimes because of complexity, bounded rationality and limited knowledge. However, when banks are nationalized, their losses would create only a very minor problem for the public finances as governments borrow money to recapitalize them*. That needn’t generate the fears of a credit crunch or financial crisis that we’ve seen recently. In this sense, nationalization would act as a circuit-breaker, preventing blow-ups at banks from damaging the rest of the economy. (Given that countries are exposed to financial crises overseas, the full benefit of this requires that banks be nationalized in all countries).

You might reply that the same effect could be achieved by demanding that banks were better capitalized, as Anat Admati and Martin Hellwig have argued: calls for 100% reserve banking are to a large extent just an extreme version of this.

However, the former would require massive share issues, which would themselves hurt stock markets. And the transition to the latter – as even its advocates acknowledge - would be complex: in fact, Frances has argued that it would kill off commercial banking. Nationalizing banks would be simpler.

You might object that doing so would impose losses upon shareholders, and the adverse wealth effects would depress demand. I’m not sure. By reducing the chances of future financial crises, the risk premium on non-financial stocks should fall, causing their prices to rise. And to the extent that banks have a positive net present value at all, their transfer to the public sector represents not a loss of wealth but a mere transfer: what bank shareholders lose, the tax-payer gains. The only wealth loss would come if banks are worse-managed in the public sector than they would be in the private – and that’s a low bar. Net, there might well be a positive wealth effect.

My point here is, however, a broader one. One fact illustrates it. During the golden age of social democracy – from 1947 to 1973 – UK real total equity returns averaged 5.1% per year. If we take the fall of the Berlin wall in 1989 as its starting point, they have returned 4.9% per year in the “neoliberal" era. This alerts us to a possibility – that perhaps some social democratic policies are in the interests not just of workers but of shareholders too. Maybe the beneficiaries of neoliberalism are fewer than one might imagine.

* Because losses are most likely to happen when the economy is depressed, such borrowing would be done when demand for gilts is high and borrowing costs low. In fact, in such depressed conditions there might well be a case for quantitative easing, whereby the Bank of England buys the bond issues directly.

Comments

Your argument in favor of nationalization is solid. But maybe you should consider the "if banks are worse-managed in the public sector than they would be in the private" part of your reasoning. I can think of one word that summarizes my concern: populism. Banks can be used for A LOT of political quid pro quo, and the history of institutions like Fannie and Freddie are quite illustrative of this problem.

Excuse my possibly naive comment, but isn't "The" Bank (ie. The Bank of England) already nationalized, and isn't that enough? Or to put it another way, if we nationalized the major commercial banks, the government might as well join them into a single bank (let's call it "The Bank of England" for short). Then other commercial banks would start up. So we'd be in the same situation as we are now.

There is an argument that much of retail banking is a utility, and should therefore be nationalised. The major banks use retail banking as a hostage to ensure that they are bailed out at times of crisis. The obvious way to resolve that risk is to separate simple public retail banking from the rest, and let the casino-worshippers take the risk with the rest.

“However, the former would require massive share issues, which would themselves hurt stock markets.” Eh? A self-styled Marxist attaches a large amount of importance to the well-being of stock markets. Bizarre.

Chris’s basic argument for nationalisation seems to be that that would enable government to pour money into loss making banks or “recapitalise them” as he puts it. Two flaws in that argument: first subsidising a loss maker is a mis-allocation of resources, unless there is a very good social justification for the subsidy. Second, the fact that banks are privately owned does not stop a government pouring money into the bank industry: indeed, governments have done just that in recent years.

I agree that banks are into the “hostage” business, as you put it. But I don’t think you’ve got it quite right. I suggest it’s money creation and storage which is the hostage.

That is, private banks create and store the vast bulk of the nation’s money supply. That means that if they screw up on the LENDING front, they can say to government, “Rescue us else a big chunk of the nation’s money supply vanishes, i.e. ordinary depositors lose their money, and there’ll be riots.” Indeed, in the 1930s before the days of deposit insurance, ordinary depositors lost $6bn as a result of bank collapses in the US.

The solution is to separate lending from money creation and storage. I.e. have government be responsible for all money creation and storage (as suggested by Milton Friedman and three other economics Nobel laureates), while LENDING is funded by equity or equity like liabilities (like bog standard corporate bonds). That way, if there’s a screw up on the lending front, lending entities do not go insolvent: all that happens is that the value of lending entity shares decline in value.

This tends to make me even more angry at what happened in '08. Thus for trivial sums in reality the rest of populace are fleeced and impoverished in some cases for what? A few bonuses for a few? All that QE and ZIRP for relative chump change!

"Put it this way. In the 2008 financial crisis, the US’s biggest financial institutions lost between them less than $150bn. But during the tech crash of 2000-03 investors in US stocks lost over $5 trillion."

"while LENDING is funded by equity or equity like liabilities (like bog standard corporate bonds). That way, if there’s a screw up on the lending front, lending entities do not go insolvent: all that happens is that the value of lending entity shares decline in value."

This idea that 'shareholders' will discipline banks is total nonsense. They are fragmented and have no control at all over large operations. They just collect the dividend or coupon.

Shareholders and bond holders didn't do a great job of managing the banks up to 2008, and they won't do afterwards. It requires hard regulation - which also has the added advantage of eliminating the cost of liquidity to the banks which makes loans cheaper.

Trying to do the 'market forces' trick just puts the price of borrowing sky high. Which is bad for the capital development of the economy.

Separating the payment system out onto a separate balance sheet is about the only half decent idea from the sovereign money people. That way commercial banks act as agent rather than principal. But it doesn't really matter because the central bank can inject the necessary assets into a bank shell whenever it needs to. So why have the centralisation complication when you can do the same thing via insurance and regulation?

"I agree that banks are into the “hostage” business, as you put it. But I don’t think you’ve got it quite right. I suggest it’s money creation and storage which is the hostage.

That is, private banks create and store the vast bulk of the nation’s money supply. That means that if they screw up on the LENDING front, they can say to government, “Rescue us else a big chunk of the nation’s money supply vanishes, i.e. ordinary depositors lose their money, and there’ll be riots.” Indeed, in the 1930s before the days of deposit insurance, ordinary depositors lost $6bn as a result of bank collapses in the US.

The solution is to separate lending from money creation and storage. I.e. have government be responsible for all money creation and storage (as suggested by Milton Friedman and three other economics Nobel laureates), while LENDING is funded by equity or equity like liabilities (like bog standard corporate bonds). That way, if there’s a screw up on the lending front, lending entities do not go insolvent: all that happens is that the value of lending entity shares decline in value."

I agree Ralph, but not with your solution. What is needed is asset side regulation.

It starts with an accounting distinction. Bank assets would be classified either as real, in other words claims on physical or distinct immaterial objects; or as financial, assets which appear as liabilities on the balance sheet of some other institution.

Next, regulators would ensure that financial assets were 100 percent-backed by common equity. And lastly, in a combined regulatory and accounting change, the value of a company’s real assets would have to be greater or equal to the value of the total of its liabilities.

This final fix is where the book goes beyond previous proposals to mend finance through concepts such as narrow- or limited-purpose banking. The implication of McMillan’s recommendation is that many derivatives, for which a counterparty’s losses could be infinite, would be banned. What’s more, the intended application to financial and non-financial companies alike would include shadow banking, addressing the so-called “boundary problem” of regulation that other approaches to improve the system fail to solve.

There is an easier and more politically acceptable alternative to nationalisation. This is for the the authorities to take powers to compel banks to raise more capital via the issue of new shares( and to prevent dividend distributions and share buybacks, or takeovers) when the authorities choose, when they feel it is necessary for the good of the economy.
Andy Haldane and Carney have not woken up to the need for these powers, they are over focused on preventing banks requiring taxpayer bail-ins, rather than the impact of inadequate bank capital on the wider economy.

I've said it before in response to Frances Coppola, but I don't see any way forward that doesn't involve separation of the basic electronic payment infrastructure from banking.

Now that could be some techno-libertarian solution like bitcoin, or it could mean nationalisation. But either way, as physical cash declines there is more and more a need to provide each person (and business?) with the means to transfer money to another entity without being locked into a potentially abusive contractual relationship with a bank.

I suppose I'm disagreeing with Ralph Musgrave here, it's not "lending" or "payment infrastructure" that gives the banks hostage power, it is both - and both will need addressing.

The system proposed in the Reuters article you link to is very similar to full reserve banking (aka narrow banking). For example, the article says “Under these rules, banks would no longer create money. Rather, independent central banks would take on that task.” That’s exactly the same as full reserve banking (advocated by Positive Money, Milton Friedman and at least three other economics Nobel laureates).

Re the suggestion that derivatives be banned, derivatives are certainly a problem, but full reserve banking in principle deals with that very neatly: anyone putting money into an entity that lends to any form of remotely risky borrower (mortgages, small businesses etc) has a choice as to what’s done with their money. If they want to place their money with something resembling an old style UK building society (which certainly does not dabble in derivatives) they can. In contrast, if they want their money to be invested in risky derivatives, they can. And if they lose all their money, s*d them.

We know what happens then. See 2008.'Market force's put up the price of money - which is bad for capital development of the economy. Derivatives, at least on things such as food, should be regulated if not banned.

This post ignores the many real changes taking place in banking. Regulation and technology are opening up banking to a variety of different players. In the near future large parts of infrastructure will be run by organisations that have no direct exposure to lending or other banking activities. Setting up a bank from your bedroom will be possible in the same way that people can set up an airline from their bedroom (i.e. leasing equipment, and plugging into the available infrastructure). More and more organisations are setting up different ways of lending - peer to peer lending, Handlesbank setting up business-focussed lending, start-up banks etc

@Dipper - You ignore significant costs of entry. You have always been able to set up a bank in your bedroom. You have always been able to create your own currency. The problem is to get either known and accepted by the populace. True *some* costs of entry are reducing. But successful entrants will still require size and/or a significant public profile.

Just to bang on about this, Governments are introducing a series of regulations that are producing a radical shift in the way banking operates. The left should take a keen interest in these changes as they address a key criticism of capitalism.

The central problem in banking was conflict of interest between banks as risk-takers and banks as providers of services to clients. Governments have moved to eliminate this. Under MIFID II Banks have to have a pricing policy that delivers fair prices to consumers and does not allow favouritism. These prices have to be generally available in electronic trading venues where clients take the best rate from competing banks, and the banks have to clear these trades and post collateral against them.

The net result is banks are paid for the effectiveness with which they deliver banking services, not for the spreads they take or the risks they run.

This should remove an occurrence of organisations exploiting positions in the supply chain to extract profits greater than the economic value of their service at the expense of other businesses. It is quite clear that this approached can be applied to many other industries such as utilities, insurance, etc.

The left like to argue that under capitalism entrenched cartels can exploit others to their own advantage. The regulations are an interesting example of markets being constructed and regulated to avoid this outcome. Leftists should be taking a great interest in this, but so far have failed to engage.

Dipper,
This is why banking is different: Banks have a macro-economic role in connecting savers with borrowers, that other companies do not have. If banks are in aggregate under capitalised, there may be in-sufficient total lending which will push the country into recession. If, say, supermarkets were under-capitalised, there might be long queues at the checkouts, higher grocery prices, big supermarket profits, but still a healthy economy.

But banks are messengers? They make decisions based on the rules and the state of the market, and the rules are in the governments control. If the government wants to increase lending then it needs to change the rules?

Dipper,
They make decisions based on the rules, the state of the market, and their own financial positions. If they have just lost a shitload (like in 2008) even if the market for making new loans is profitable, they may not be in a position to take advantage of these opportunities and their may be a shortage of new loans. In a super efficient market, new banks would be created in bedrooms with billions of pounds of capital to take up these opportunities. Unfortunately, bedrooms get used for other activities instead, the opportunities go unexploited and economies go into recession. Nationalisation is one answer; I dont like it but prefer forced recapitalisation.